The term ICO refers to an “initial coin offering”, i.e. a public sale of digital tokens or coins, to which various rights may be attached. Although there is no generally recognized classification, industry experts and some regulators have started referring to several categories of tokens based on the underlying economics, as determined on a case-by-case basis after review of the white paper published by the founder team.

• Payment Tokens or Cryptocurrencies: Modeled after Bitcoin (BTC), some tokens (or coins) have no rights attached giving the holders a claim against the issuer, but they are designed to be limited in quantity, similar to precious metals, so that their value may increase based on their adoption by various users. Their value is also tied to the benefits provided by the blockchain platform they are built on (e.g., security, decentralization, disintermediation, anonymity or pseudo-anonymity). Although Mastercoin is generally regarded as the first ICO, Ethereum (ETH) was more successful in 2014, raising 25,000 BTC from investors in the first two weeks of the public sale and later on developing Ethereum as the largest platform for ICOs.
• Utility Tokens: Most ICOs sell tokens which are designed to provide access to an application or service on a blockchain-based platform. Such tokens may be “burned” upon use, but new tokens can generally be purchased on the same platform. Such tokens are the blockchain version of digital coupons, but with the additional benefit of being tradeable securely and pseudo-anonymously (and benefiting from a potential increase in value if the number of users of the platform increases).
• Asset Tokens: Tokens which give the holder a portion of the profits of the business or other economic rights are considered to be securities in several jurisdictions, i.e. a blockchain version of equity interests, debt instruments, etc.
• Hybrid or Other Tokens: Any combination of the above can generally be considered a hybrid token; this may trigger an overlap of applicable regulations.

In some cases, the same blockchain project generates two or more categories of tokens with different rights attached, which are issued in the different stages of the project. In other cases, investment contracts for future tokens (SAFT, SAFTE, and several other variations) are signed before an issuance, enabling the founder team to develop a working model of the blockchain project before any “public” sale. Finally, some blockchain start-ups do not offer any type of coins or tokens.

The assumption would therefore be that issuing tokens in a certain “category” would trigger regulation, while another “category” may not. Such assumption, however, if not confirmed by review by specialist legal counsel, exposes the issuer to substantial legal and regulatory risks, especially since the regulators’ position, as expressed through “Guidance Notes” or unofficial statements, may change over time.  Also, ICO founder teams are generally based in multiple jurisdictions, and promotion efforts may target investors from various countries. Without realizing it, ICO founder teams may in fact be required to comply with several very different regulatory environments.

As at the date of this publication, there is still no specific regulation in the Cayman Islands addressing ICOs and blockchain technology. However, several of the existing laws and regulations are applicable to blockchain start-up companies and their pre-ICO and ICO operations. Also, a recent series of statements have been made by the Cayman regulatory authority, which generally encourage the blockchain ecosystem development. The Cayman Islands Monetary Authority (“CIMA”) itself has unofficially commented that cryptocurrencies, ICOs and FinTech generally are here to stay and that although the Cayman Islands Securities Investment Business Law (2015 Revision) (SIBL) does not include cryptocurrencies or tokens in its list of securities , CIMA may be issuing further guidance to issuers and promoters as they increasingly look to access “real money” through the offshore funds industry.

As things currently stand, ICO founder teams and promoters looking at the Cayman Islands for incorporation of their company or companies should be aware of the following best practices:

1. Have a Real Project. Setting up a Cayman Islands exempt company for your ICO (the “Company”) is not complicated and it usually only takes a few business days. However, a successful project requires more than a legal entity. Based on your business model and strategy, the legal vehicle which may be best suited for your purposes may also be different: for example, a foundation company instead of a regular exempt company may work best if your purpose is to create a stand-alone blockchain ecosystem, not “owned” by a particular person or group of persons. For more details regarding Cayman Islands foundation companies, see our alert Foundation Companies can now be incorporated in the Cayman Islands. Generally, the founder team should be prepared to answer the following questions:

• • What are the key features of the service/platform to be developed?Which market participants (investors) will the ICO target? Are there any restrictions regarding investors? Are the founders planning to bring in pre-ICO investors on a private placement basis (through SAFT agreements or otherwise)?
  • What is the project timeline (ICO phases, milestones, etc.)?
  • What technologies will be used (new or existing, open source project vs. blockchain patent envisaged, etc.)
  • Which cryptocurrencies will be accepted? Will the ICO have a floor or a cap?
  • Have the funds already been allocated to a specific project? How will surplus funds be handled?
  • Will a token be created in the course of the ICO?
  • Which functionalities are planned for the token? What rights will be attached?
  • At which point, by whom and in which manner will the token be transferred to the investors?
  • How can the token be transferred (compatible wallets, technical standards)?
  • Is the token already functional at the time of transfer? If yes, to what extent?
  • How and where can the token be acquired or sold after the ICO (secondary market platforms)?
  • Will it be possible to use the tokens to buy goods or services or make payments to third parties?
  • Are there plans for the Company to buy back tokens?
  • Which service providers will be involved with the ICO?

2. Have a Real Lawyer. A lot of the information generally available on the web about setting up a company or opening up a bank account in the Cayman Islands is inaccurate. Even going to a real CIMA-regulated corporate service provider may not be sufficient in itself, as they will only be able to help with setting up the company and certain basic compliance issues. It is imperative that founder teams use legal counsels who regularly operate within the ICO space and have detailed, specialist knowledge of the regulatory landscape. As shown by the recent wave of enforcement actions and subpoenas in the United States , regulators will not hesitate to go after ICOs if not properly carried out, and the founder team may be forced to return funds, raise compliance standards or face sanctions.

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Notes

1. EY research: initial coin offerings (ICOs), December 2017, in which Ernst & Young studied 372 ICOs having raised US$3.7b in funds.
2. Such as FINMA, the Swiss regulator – see https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/
3. From the Ethereum self-published statistics – see https://blog.ethereum.org/2014/08/08/ether-sale-a-statistical-overview/
4. It has been pointed out by many that although blockchain gives the impression of anonymity, in reality most wallets can be linked to a physical identity and in reality only offer a sort of pseudo-anonymity. For example, KYC/AML obligations apply to all cryptocurrency exchange platforms and buying cryptocurrencies on such exchanges is subject to the user providing government-issued identification.
5. For this reason, it may be considered that all tokens are in reality bought for speculative purposes and therefore all tokens (even utility tokens) should be treated as securities in the US (among other jurisdictions).
6. For example, China and South Korea have banned all ICOs. Other regulators have issued warnings to investors and guidance notes, but reserve the possibility to adopt a specific ICO-related regulation or take action at a later stage.
7. Quote from Ms. Heather Smith, Head of Investments & Securities Division of the Cayman Islands Monetary Authority (CIMA), during the Opalesque 2018 Cayman Roundtable.
8. Schedule 1 of Cayman Islands Securities Investment Business Law (2015 Revision) (SIBL) exclusively refers to shares (including stock of any kind in the share capital of a company, interests in a limited partnership, or units of participation in a unit trust), instruments creating or acknowledging indebtedness such as debentures, debenture stock, loan stock, bonds, certificates of deposit and any other instruments creating or acknowledging indebtedness, instruments giving entitlements to securities, certificates representing certain securities, options, futures and contracts for differences.
9. Quote from Ms. Smith during the Opalesque 2018 Cayman Roundtable, see FN vii above.
10. On 24 August 2017, following a request for information from the Securities and Exchange Commission (SEC), Protostarr cancelled its ICO and refunded its investors. On 4 December 2017, the SEC obtained an emergency asset freeze to halt the ICO of Quebec-based PlexCorps. On 11 December 2017, the SEC ordered Munchee Inc. to cease and desist its ongoing token sale. On 17 January 2018, the Enforcement Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth brought an enforcement action against Caviar, a Cayman Islands company, and its founder. On 30 January 2018, the SEC obtained a court order to halt the ICO of Dallas-based AriseBank for allegedly conducting a fraudulent ICO.

Other than offering a tax neutral jurisdiction for international investors, the Cayman Islands benefit from financial and political stability, a business-friendly regulatory environment, a sophisticated legal regime based on English common law with a respected court system and a pool of highly skilled professional service providers; all of these factors combine to make it a jurisdiction of distinction for equity financing.

The flexibility of Cayman Islands exempted companies is certainly one of their main appeal. For example, Cayman Islands’ corporate law does not require any director or officer of the exempted company to be resident in the Cayman Islands. An exempted company which is not regulated is not required by statutory law to hold an annual general meeting of its shareholders. Equally, there is no statutory requirement for a non-regulated exempted company to undertake an annual audit. More on the advantages of using Cayman Islands exempted companies for investment purposes here: Advantages of Using Cayman Islands Exempted Companies for Investment Purposes and to… – Loeb Smith.

Whilst investors in PE and VC investment companies would ordinarily look to realise their investment within 3-6 years, these exit strategies have been severely impacted in recent years by macro-economic factors and geopolitical developments, which have made it increasingly difficult for investors to exit their investment. In this economic landscape, investors may have to explore less traditional routes to exiting their investment. In this article, we seek to provide some insight on how investors can navigate the not-so-unconventional waters of exit enforcement when issued with preference shares in a Cayman Islands exempted company.

In usual circumstances, the memorandum and articles of association of the exempted company as well as the subscription and shareholders’ agreements are drafted to include various investor protection provisions such as preference dividend rights, liquidity preference rights, exit rights on the occurrence of certain events, and rights to redeem preference shares in the event that anticipated trigger events for an exit do not materialize.

Investors in Cayman Islands exempted companies ought to be aware that under Cayman Islands law, dividends can only be paid out of available profits or from the company’s share premium account, however, in the latter case, such payment can only be made if immediately following the date on which the distribution or dividend is proposed to be paid, the company is able to pay its debts as they fall due in the ordinary course of business. More on dividends and on what constitutes profits here: Payment of dividends by a Cayman Islands company and what constitutes “profits” – Loeb Smith.

Similarly, it should be noted that the Cayman Islands’ Companies Act (As Revised) prescribes that share redemptions and share buybacks can generally only be funded out of profits, out of a company’s share premium account or out of the proceeds of a fresh issue of shares. However, in limited circumstances, a company can make a payment out of capital provided that immediately following the date on which the payment out of capital is proposed to be made, the company is able to pay its debts as they fall due in the ordinary course of business.

Interestingly, in what is a leading authority on the matter, the Cayman Islands Court of Appeal has held that the cash flow test of solvency mentioned above is not confined to consideration of debts that are immediately due and payable but also permits consideration of debts that will become due and payable in the reasonably near future.

The provisions on distribution of the company’s assets on a winding up or a liquidation under Cayman Islands law are also drafted so as to prioritise creditors over shareholders, and within this group, in particular, preferential and secured creditors. The law of voidable preference which is written into the Companies Act may also be invoked in the event the directors of the exempted company had paid a particular shareholder or a redeemed shareholder ahead of other creditors at a time when the company was unable to pay its debts with a view to giving such redeemed shareholder a preference over the creditors. In such circumstances, such transactions would be voidable upon the application of the company’s liquidator if made within six (6) months of the commencement of the company’s liquidation.

Against this backdrop of limitations on dividends, redemptions and distributions are directors’ fiduciary duties. The duties of directors of a Cayman Islands exempted company are found in the common law and include, amongst others, the duty to act in good faith in the best interest of the company. It is important to note that whilst in many circumstances the best interest of the company align with the best interest of its shareholders, this is not always the case, particularly when a company is nearing insolvency. In those circumstances, the directors, as part of their duties, will likely put the company’s creditors’ interests ahead of the interests of its shareholders and may find themselves unable to satisfy redemption requests from shareholders. This is in spite of the investor protection provisions which may have been negotiated into the preference share financing documents.

Notwithstanding the above, there may be benefits in submitting early redemption requests in situations where the company is in financial difficulty. As a first step, however, any shareholder looking to submit a redemption request should familiarize themselves with the procedure and, if necessary, consult with their legal counsel as procedural compliance can often be the difference between a simple shareholder and a creditor. The company’s articles of association and/or shareholders’ agreement usually set out a detailed procedure where certain steps must occur within a strict timeframe for the redemption request to be valid.

Where there has been a valid redemption request which has been accepted but the company has failed to satisfy, such failure has the important effect of raising the investor’s status to that of an unsecured creditor as opposed to a mere shareholder. At this point, the investor/unsecured creditor has the option to either (i) commence legal proceedings, or (ii) issue a statutory demand to the company requiring it to pay the sums owed under the accepted redemption request within twenty-one (21) days of the date of service.

Option (i) (i.e. the commencement of formal legal proceedings), will be subject to whatever terms regarding dispute resolution were contractually agreed between the investor and the company in the preference share financing documents. Arbitration is often found in these types of agreements. Whilst commencing legal proceedings against the company may cause the company to pay the sums owed, these proceedings are often time-consuming and expensive and, in the event such proceedings are successful and the investor comes out with a judgment or an arbitral award in its favour, even then it may be difficult for the investor to enforce judgment that against the company if the company is insolvent as preferential and secured creditors would take priority under Cayman Islands insolvency law.

Option (ii), on the other hand, only requires the investor to issue the company with a formal letter in a prescribed form called a “statutory demand” requiring it to pay the debt owed within a prescribed period or dispute the debt. Should the company fail to engage, this provides rebuttable evidence that the company is unable to pay its debts as they fall due and such evidence can be used as the basis for winding up proceedings against the company. The next step would then be to petition the Cayman Islands court to wind up the company. It should be noted, however, that a public notice will be advertised which will give other interested parties the opportunity to join the proceedings. The scheduled hearing may result in the company being placed into liquidation unless it can raise a substantive defence as to why the debt has not been paid. Once the company is in liquidation, the appointed liquidator will look into its accounts, realise the company’s assets and pay the creditors in ranking order.

One of the defences that companies often raise in winding up proceedings is that of lack of “legally available funds”. This is due to the fact that when it comes to negotiating the initial set of documents for the preference share financing, provisions restricting the payment of redemptions to situations when the company has “legally available funds” will often be drafted into the articles of association and/or the shareholders’ agreement. It then becomes a question of interpretation as to what “legally available funds” actually means in that particular context. Cayman Islands courts have held such term to mean funds owned by the company or funds that the company could obtain by exercising its legal rights, however, such funds would not include any monies which are required for the company’s ordinary course of business. Generally speaking, to the extent that wording has been drafted into the documents and the company does not have sufficient legally available funds to satisfy the redemption requests, Cayman Islands courts are inclined to hold such a defence as a genuine and substantive dispute of the debt and have set aside winding up proceedings on that basis.

As mentioned at option (i) above, arbitration clauses are often drafted into preference share finance documents and Cayman Islands courts would ordinarily grant a stay of a winding up petition based on a disputed debt where the underlying dispute falls within the scope of an arbitration clause. Importantly, however, the stay of winding up proceedings in favour of arbitration is not automatic and the Cayman Islands courts will first need to be satisfied as to the existence of a bona fide dispute on substantial grounds prior to being able to exercise their discretion to stay the petition in favour of arbitration. In other words, the Cayman Islands courts will not stand for any delaying tactics where there does not appear to be a genuine dispute of the debt.

If a company has run into financial difficulties, there may be scope for the company and the investors to come together and agree to a voluntary restructuring. Where a consensual solution cannot be reached with all interested parties, the agreement may take the form of a court-supervised process such as a scheme of arrangement which may have the potential for a better return to investors than a liquidation of the company.

The corporate team at Loeb Smith has extensive experience in advising companies and investors on the negotiation of these finance documents, the enforcement of redemption requests and the implementation of suitable strategies and solutions for financially-stricken companies.

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This publication is not intended to be a substitute for specific legal advice or a legal opinion. If you require further advice relating to the matters discussed in this Briefing, please contact us.  We would be delighted to assist.

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Entities which are regulated by CIMA should provide accurate and timely information to stakeholders, including shareholders (or interestholders in a limited partnership) and regulators. This includes financial reporting, compliance filings, and any material changes that could affect shareholders/interestholders.

The board of directors of a Cayman Islands company (“Board”) may delegate some of its responsibility to others (e.g. the Board of Directors of a Fund delegating management of its assets to a Fund Manager) but is nonetheless required to exercise supervisory oversight and control over those delegated functions and moreover the Board should be accountable for its actions and decisions. This includes setting clear roles and responsibilities, establishing performance metrics, and ensuring that there are mechanisms in place to evaluate the performance of the Board and management.

Depending on the subject matter of the rights and entitlements in question, shareholders (particularly those in the same class) should be treated fairly and/or equitably, with their rights respected and any conflicts of interest managed appropriately.

The Board should be composed of qualified individuals with the appropriate diverse skills, experience, and independence to make informed decisions. Regular assessments of Board performance and training opportunities are encouraged to enhance effectiveness.

Effective risk management frameworks should be in place to identify, assess, and mitigate the internal and external risks that the company faces. This includes financial, operational, legal, and reputational risks.

Companies must comply with the legal and regulatory frameworks applicable in the Cayman Islands, including the Companies Act, the Beneficial Ownership Transparency Act, the Securities
Investment Business Act, the Mutual Funds Act, the Private Funds Act, and relevant guidelines issued by regulatory bodies such as CIMA.

Companies should promote and adhere to high ethical standards and conduct business with integrity. This involves establishing codes of conduct, policies to deal with conflict of interest appropriately, anti-corruption policies, and procedures for reporting unethical behaviour.

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By following these principles consistently, Cayman Islands regulated entities can effectively enhance their corporate governance practices, comply with Cayman Islands legal requirements and thereby avoid fines and penalties, align with best practices globally, and foster trust among their stakeholders.

This publication is not intended to be a substitute for specific legal advice or a legal opinion. For specific advice on Corporate Governance, please contact your usual Loeb Smith attorney or any of the following:

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